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Why Quarterly Earnings Guidance Should End

Just like in the movie War Games, the only winning move is not to play.

One of the most destructive things many companies do is to provide guidance to Wall Street about how the current quarter and the near-term future will turn out. It's destructive because the moment a company's executive states an earnings target, meeting that target typically becomes way more important than virtually anything else.

After all, there's more than just their reputation on the line. According to a Harvard Business School study, C-level officers who missed guidance were more likely to feel it in their pocketbooks, thanks to penalties ranging from lower bonuses to outright dismissal. A little pressure can be a good thing, of course. Unfortunately, though, when the choice becomes "make the numbers" or "build the business" and the penalty for missing the numbers can be termination, the long-term business generally suffers.

Game theory and earnings guidanceTo make matters worse, to the jaded analysts on Wall Street, guidance becomes something of a game. "Whisper numbers" of what the analysts really think will happen become based on not only the company's guidance but the company's history of meeting, beating, or falling behind that guidance. And those analysts are no dummies, either -- they know the historical practice of "cookie jar accounting" and the still-legal ways to "pull forward" sales through practices like limited-time deep discounting.

Automakers are the masters of such pull-forward practices, with General Motors(NYSE: GM) routinely turning in sales numbers that are aided by dealer inventory builds. Or in other words, many of those sales count as sales from the manufacturer's perspective, even though they don't immediately make it to the hands of actual consumers.

As a result of all that, earnings guidance itself often winds up saying less about the company's prospects than it does about how good management is at pulling the right accounting levers to reach its targets. Indeed, the analyst decision tree begins to look something like this:

If a Company...

Then the Analysts...

Fails to meet guidance

Wonder how bad it must really be, since the company clearly ran out of levers to pull.

Meets guidance

Start questioning whether the company is aggressively building the business or simply managing to expectations.

Beats guidance

Begin assuming management was "sandbagging" by providing low guidance it could easily beat.

There really is no winning outcome from providing guidance, so the real question becomes: Why bother delivering it? Indeed, after earnings are reported, regardless of whether they meet, beat, or fall below expectations, a company's stock can move in virtually any direction at all.

Which way did they go?Sure, you'll find cases in which companies are punished for failing to meet expectations. Big Lots(NYSE: BIG) saw its shares pummeled last month when its results fell short of targets. In a business like Big Lots that depends on closeout merchandise, it's often tough to predict the future since so much of its success depends on other companies' overproduction rather than its own innovation.

Still, if you take a step back from the immediate consternation, even missing earnings doesn't necessarily doom a company to failure. For instance, titan Apple(Nasdaq: AAPL) missed earnings in July and saw its shares immediately stumble on the news. Yet the very next month Apple's shares raced to an all-time high after a court ruled in its favor in a patent dispute with Samsung. So clearly, missing earnings doesn't doom a company to long-term failure -- as long as its business is fundamentally strong.

On the flip side, even beating expectations is no guarantee of success, as video rental giant Netflix(Nasdaq: NFLX) found out when it most recently reported earnings. In spite of turning in earnings that more than doubled expectations, its weak outlook on the back of its challenges in trying to monetize streaming videos slammed its stock. As with Apple, Netflix showed that over time the fundamental strength (or lack thereof) of the business, not its ability to hit this quarter's numbers, matters most.

It's not just bad guidance that can temporarily pull down a stock. Medical device company Abiomed(Nasdaq: ABMD) beat expectations last month and raised the low end of its guidance, only to see its shares quickly fall on the news. The stock later slumped on the news of the death of its founder, but has since mostly recovered on both the strength of its business and persistent takeover speculation.

What if they get it right?Perhaps worst of all, companies that are successful enough at the guidance game to keep doing it tend to develop a case of shortsightedness that often leads to underinvestment in their businesses. After all, the "easy" expenses to cut are often things like research and development that don't necessarily provide near-term benefits but do drive long-term growth.

With a decreased focus on the things that drive long-term growth, the long-term returns for shareholders are diminished. After all, over time, your investment returns are determined largely based on how far and fast a company grows and how much value it directly returns to you via dividends and intelligently priced buybacks. Everything else -- including whether it met, beat, or fell behind last quarter's earnings expectations -- falls out as mere noise in the inexorable march of time.

The only winning move is not to playSo why bother guiding? If the best you can hope for is mediocre growth driven by managing the business to meet expectations rather than working to generate long-term value, is that really a prize worth winning? This investor would much rather see the short-term volatility and surprises -- both positive and negative -- that come from managing the business for long-term value creation.

Stability is nice, but if predictable cash flows were all that mattered to investors, there are other forms of investments -- like investment-grade bonds -- that would be a better place to invest than stocks.

At the time of publication, Fool contributor Chuck Saletta did not own shares of any company mentioned in this article. Click here to see his holdings and a short bio.

Author

Chuck Saletta has been a regular Fool contributor since 2004. His investing style has been inspired by Benjamin Graham's Value Investing strategy. Chuck also can be found on the "Inside Value" discussion boards as a Home Fool.